Learning Techniques for Stock and Commodity Options_12 doc

c24 JWBK147-Smith April 25, 2008 11:16 Char Count= How to Make Money Trading Options 287 them to another level and created his own mechanical methods. He got his quote screen all set up and was ready to trade. I helped him out by enabling him to open an account at the same broker that I used. Normally, the broker only handles institutional accounts but he decided to allow my friend to open an account with only $10,000 as a favor to me. He also allowed him to trade at institutional commission rates that are roughly half those charged by retail brokers. He then proceeded to lose about 60 percent of his bankroll over the next six months. This was a terrible track record since it meant that he was losing consistently because he was able to keep his risk to below a couple of hundred dollars for each trade. That means he had a lot of losing trades. It was quite remarkable because the system he was trading had very little discretion and had such a tremendous track record while being tested. He went back over the track record of the system during the time that he was actually trading it. Turns out that he had lost 60 percent but the system was profitable. In other words, he was not actually following the system. He was not executing the trades according to the signals. It turned out that he was intimidated by calling an institutional broker and only putting in a one or two lot order. He felt that he was wasting their time since they were used to dealing in larger quantities and that they were doing it only as a concession for me. The brokers had never complained but my friend had projected a problem where none existed. He would hesitate before entering a trade and end up missing many trades and creating a huge slippage problem. The solution was obvious. Shift his account to a retail broker that charged twice as much and gave poorer service! By shifting his account to a retail broker, he felt that he wasn’t both- ering anybody and could go back to focusing on the market instead of his relationship with his broker. He was getting worse fills and paying twice as much in commissions but was starting to make money. He had found a bizarre little problem in his mind that was stopping him from making money. The good news is that he could easily solve the problem. EGO Why do we lack self-discipline? No one can say for certain but I believe that our ego is the primary cause of a lack of self-discipline. We need to validate ourselves and show that we are a good person. Our ego has huge needs that get in the way of trading success. I’m not saying that the ego is all bad. On the contrary, we need to have a strong ego to trade again after being beat up in the markets. We have to c24 JWBK147-Smith April 25, 2008 11:16 Char Count= 288 OPTION STRATEGIES feel strong enough to take the psychological pressures of trading and keep going. But the ego is also likely the cause of nearly all long-term trading losses, in my opinion. It’s not natural to trade. We have to overcome our ego to be successful yet still allow our ego to motivate us to make money. We are constantly trying to find the fine line between humility and egomania. THE PRESSURES OF TRADING The pressures of trading are extreme. You feel elation when you have a big winner and depression when you have a big loser. Unfortunately, these emotions are the enemy and you’ve got to over- come them. Many of the most successful traders that I have known have ice water in their veins. They remain cool and calm no matter what good or bad events are swirling around them. Legendary futures trader Richard Dennis stated that trading is almost against human nature. We have met the enemy and it is us. Much of the issue of self-discipline is finding ways to overcome our natural impulses driven by fear and greed and the other motivations out- lined in the beginning of this chapter. Perhaps we need to distract ourselves from what is really driving us, to something more manageable that we can control. The pressure of making and losing money creates a lack of objectivity that clouds your mind and therefore creates dubious trading ideas. The first goal is to reduce these pressures and help us to become calmer about our trading. TREAT TRADING AS EDUCATION Rather than think of trading as a means of making or losing money, think of what you can learn from each trade and from trading in general. Think of trading as going to university but with a pop quiz every day. Focus on what you are learning as you go through the trading experi- ence. Every time you exit a position, look at the trade and try to identify what you learned rather than how much money you made or lost. Did I analyze the commodity correctly? Did I understand the driving forces that caused it to move? What should I learn before my next trade? Did I follow my plan? Did I enter the trade well? Did I exit the trade well? What were my emotions while I entered/exited the trade? What could I have done better? What did I do well? What did I do poorly? c24 JWBK147-Smith April 25, 2008 11:16 Char Count= How to Make Money Trading Options 289 This should give you an idea of the questions you can ask yourself to further your education. The point is to focus like a laser beam on learning, not on your profit and loss. Normally, people focus on how much money they have made or lost. But, in a way, that is irrelevant. Money will be made or lost on every trade. The real issue is whether or not your bankroll is increasing over a longer period of time, say a month, a quarter, or even a year. It is highly unlikely that you will make money over the long run if you do not constantly improve as a trader, particularly if you are not currently a profitable trader. I have been a professional trader for about 30 years and have had only one year that was even close to a losing year. But I still spend a tremen- dous amount of time trying to improve my craft. I bought the trading jour- nal Commodity Traders Consumer Research in 1996 from Bruce Babcock. One of my primary reasons for buying it from him was that it gave me the opportunity to interview and learn from some of the best minds in the op- tions industry and also allowed me access to books, systems, and other products so that I could learn more. If I do not constantly strive to learn then I will be caught when market conditions change. I used mechanical trading systems extensively back in the 1970s and 1980s. I got very nervous about the efficacy of them in the late 1980s when I saw Mint (a very large commodity money manager) acquire $1 billion under management. They were the first to achieve that amount of money. They used a standard trend-following method based roughly on a 40-day moving average. I felt that if there was a company with a billion dollars under manage- ment then that particular style would find it very difficult to make money–it had so much buying and selling power that it was the market. It would dom- inate the market so much that it would not be able to make money. There would not be enough liquidity in most markets to allow them to diversify. Remember, Mint was only the tip of the iceberg. They had a billion dollars but there were lots of other plain vanilla trend followers in the mar- ket at the same time. After all, I was one of them. I wasn’t doing anything special in my trend-following systems. I felt that the returns to trend-following systems would degrade be- cause there was too much money flowing into the market all at the same time and that would mean that the profits from the system would not be as high as they had been in the past. I decided that I would have to change my method of entry and exit. I use fundamentals to determine the direction that I want to trade in and use mechanical systems for the entry and exit. If mechanical systems were being overused then I would have to learn an en- tirely different method of entry and exit. I ended up switching to a classic chart analysis method. c24 JWBK147-Smith April 25, 2008 11:16 Char Count= 290 OPTION STRATEGIES It turns out that trend-following systems did, in fact, go through a pe- riod of poor performance. (I think that the amount of money under man- agement of trend-following systems has been reduced, as a percentage of the total amount under management, and that trend-following system will again produce good results.) The point is that I had to be alert to the fact that what I had been doing may not work in the future and I had to learn a new skill or I was out of business. I had to make sure that I had backup skills in case my current skills were no longer being rewarded by the market. Conditions change—make sure that you are prepared for it. A focus on constant learning is essential if you are going to be in this game for a long time. Market conditions change and you must be alert to those changes and have a depth of knowledge to draw from if you need to change your trading strategies or tactics. I believe that trading success is built on the excellent execution of a few fundamentals. You don’t need to get fancy, just focus on the basics. I think that you will find that most of your losing trades come from breaking a few fundamental rules, such as not placing and sticking to a pre-set stop loss level. Switching the focus onto learning and away from profits and losses helps to reduce the emotions associated with trading. You can look at each trade much more objectively because you almost don’t care if you made or lost money. In a curious way, you might even “enjoy” losing trades more than winning trades because you can usually learn more from the losers! Notice that this orientation helps to promote good trading practices. Remember, you should be noting everything you did right in the trade as well as what you did wrong. This will reinforce behavior that produces profitable trades. In a way, the definition of a “good” trade changes. A good trade be- comes a trade where you learn something new, not one that makes money. Notice the powerfully different mindset between these two directions. Making or losing money on a given trade becomes no big deal. Instead, you try to dispassionately analyze your trading to see how to improve. You are almost forced to be objective. The flip side is that a tremendous pressure will be released. You are no longer judged (by yourself) by the success or failure of your last trade. The pressure is replaced by the pressure to improve as a trader. That is a much nicer pressure to feel and will lead to better trading and more profits. It is much better to kick yourself for not learning as much as you could than to kick yourself for losing more money. You will be motivated to study your trading rather than feeling sorry for yourself or angry with yourself. Focusing on your own trading will also tend to keep you from rely- ing on others for your profits. It is possible to use systems and ideas from c24 JWBK147-Smith April 25, 2008 11:16 Char Count= How to Make Money Trading Options 291 others but you will never learn anything. In the final analysis that is OK but few people have the self-discipline to simply follow a system. Most people want to have some input into the trading decision. This ties back to the ego problem. The bottom line is that changing your focus from making money to constantly learning will sharply reduce your stress level, keep you focused on learning how to make more money, and increase your self-discipline. Notice that you can divide those answers into several categories. Most of the responses fall into the category of discipline. I have found that the trader’s discipline is the most important factor driving trading profit. Disci- pline comes into play in several different ways. First, you have to be disciplined in your trade selection. It is a common mistake for traders to talk themselves into a trade rather than keep them- selves objective about the factors supporting or not supporting the trade. A trader will often approach a trade with a preexisting bias and then find evidence and factors to support this bias rather than come to the trade with an open mind. Second, you have to stick to your plan. Let’s say you are running a program of covered calls. Often traders will stop trading when they have a few losers in a row. They will begin to doubt their strategy and, even worse, themselves. They will think that the strategy is defective. Perhaps the software they are using is no good. They stop trading and start to tinker with the strategy. Perhaps they should only do covered calls with in-the- money options so there tends to be more down-side protection. Perhaps I’m not a good trader. Perhaps I should double up my positions to catch up on those last few losing trades. Perhaps I should just stop trading because I’m not a good trader. Casting doubt on your strategy or even on yourself can be wise. But it usually happens after just a few losing trades. Instead, traders must stick to a strategy until there is a significant number of executed and closed trades. Only then can a rational course of action be created. One of the critical psychological factors that drives investment success is being consistent and persistent. This means that we do not constantly shift strategies or tactics. It means that we continue to probe the market looking for opportunities to make money. It means that we don’t bail out of a strategy just because it has a bad run of losses. I have taught many traders how to trade and I see this as one of the most common problems for traders. They read a book, such as this one, and become enthralled with the idea that they can make a lot of money trading options. In fact, you can make a lot of money trading options. However, it is not easy. Traders begin their trading with eagerness and high expectations. Then the hard reality sets in that not all trades will be winners and not all winners will be big winners. Or they start out with idea that they can be c24 JWBK147-Smith April 25, 2008 11:16 Char Count= 292 OPTION STRATEGIES consistent sellers of premium so they have a few winners and then the inevitable demoralizing big loser comes in. They then throw up their hands and flinch. They may stop trading en- tirely or they may start to take just some of the trades. They may start to override their original strategy and only take trades “they think will do well.” Of course, this is doomed to failure. What will happen is that they will inevitably pick the losing trades and ignore the profitable trades. Per- haps I’m being cynical but I’ve seen it happen too many times to not ex- pect it. Of course, this just leads to more frustration, more losses, and fi- nally they throw in the towel mumbling something about how the game is rigged or something similar to throw the blame onto someone other than themselves. Another common example of the effect of psychology dominating trad- ing is the common action of taking a profit before it was planned. Com- monly, the trader has had a run of bad trades and finally has a position that starts to make money. They were originally planning to make $1,000 on the trade but the temptation of booking the current $300 profit proves to be too high. They override their original strategy under the influence of finally having a profit. I’ve often heard from traders that you can’t go broke taking a profit. In fact, you can. There are always going to be losses in a trading program. Profits at the end of the year will depend on whether or not there are enough profits to cover those losses. Cutting profits short of their poten- tial is a sure way to create a losing program at the end of the year. Sure, the trade will be profitable but the program will be a failure. Another common strategic mistake is to bail out of an existing position when some news item breaks. They immediately jump out of the position, particularly when the position is starting to go against them. They rational- ize that the news item changes their strategy. On the face of it, this seems sensible. Surely we should be able to enhance our profits if we take into account the freshest information rather than relying on the stale informa- tion that we had when we first put together our plan for this trade. Actu- ally, traders tend to do worse when they override their original plan and change it in midstream due to a news item. I did an informal study of the professional traders that I was managing to see if this was true. It turned out that following the original plan was more profitable than the new trade over 80 percent of the time. This shocked me. Why would traders do worse having current information compared with sticking to what should be an obsolete plan? I think the answer comes from several directions. The original plan was made in a cool and calm state of mind. The new plan is made under pressure and under the gun. The original plan was derived after careful and objective consideration of the facts. The new plan is made after instant c24 JWBK147-Smith April 25, 2008 11:16 Char Count= How to Make Money Trading Options 293 analysis of perhaps only one new fact. I believe that this study shows that traders have a very hard time properly evaluating new information under pressure and when they are emotionally involved with the current trade. Instead, they are better off sticking with the original plan. THE TRADING PLAN Perhaps the most powerful technique for increasing self-discipline is the use of a trading plan and the attendant post-mortem technique. I am going to go into more detail about this technique and will show real examples of a trading plan. A lot of the losses come from making stupid mistakes. You forget to put in the stop because you will do it tomorrow. You don’t know the right contract size. You like the way the stochastics are acting but completely ignore the breakdown on the chart. And so on. In other words, you simply forget to take a look at something that you know you should look at. I think that the two main reasons for not paying proper attention are: 1. Too busy a schedule or simply not caring. 2. Not wanting to confuse your opinion with facts. I firmly believe that the consistent use of a trading plan will overcome these problems. I also believe that the trading plan is the second most im- portant part of a trade, after money management. The actual entry and exit techniques are secondary. Most traders will find this statement hard to ac- cept but most profitable traders, even if they do not use a trading plan, will agree with me. And there are several reasons why. Without proper monitoring, you will drown in a flood of information. With a trading plan, all the relevant fundamental and technical indicators can be stored in one spot. It will allow you to outline a scenario of expecta- tions for the future. In addition, it provides a place for the exact entry and exit points to be delineated and necessary money management principles to be applied. One of the important features of the trading plan is that it be devised before the money is risked. Traders are typically far less emotional about a trade before the money is committed. Typically, traders lose their objec- tivity when their money is on the line. The trading plan also helps to educate you. After a trade, you can go over your trading plans and what actually happened. This is called the post- mortem. You have an opportunity to examine how accurate the pre-trade analysis was and discover areas of weakness in your own education or c24 JWBK147-Smith April 25, 2008 11:16 Char Count= 294 OPTION STRATEGIES insights. Often, investors will realize that certain facets of their trading technique have been over- or underestimated. They think that a particular technique is doing well, when, in fact, it is doing poorly. Traders can refer back to the trading plan to determine whether things are going as planned and whether there have been significant changes that will affect the analy- sis that led to initiating the position. The trading plan thus becomes a rud- der for the average speculator, who tends to trade like a rudderless ship. When investors are forced to commit thoughts to paper before initiating the trade, their thoughts must be more logical and coherent. A record of your thoughts before the trade was initiated provides a useful insight for future growth. The use of a trading plan is also a viable way of reducing mental fatigue and anxiety. The trading plan is a record of the thoughts of the trader before the trade is initiated. It represents a more calm, detached state of mind than will exist when money is on the line. Traders who have committed money based on a rational trading plan will be able to refer back to that trading plan and use it as a touchstone of calm. FILLING OUT THE PLAN Many people believe a trading plan is a waste of time. Filling out a trading plan does take time but is probably a major time saver in the final anal- ysis (see Figure 24.1). Most average speculators will spend a tremendous amount of time and energy watching the market on a tick-by-tick basis. This seems to be based on the psychological concept that if they do not watch the market it will go against them. This constant staring at a screen is an incredibly time-consuming activity. There is a major loss of energy when a trader’s mind is unfocused and the trading plan enforces a certain discipline, requiring that traders specify the entry and exit points and the method of stop placement before the trade is initiated. This means that traders can enter entry and exit points once a day rather than staring at a screen all day long looking for clues to the future direction of the market. The plan will reduce impulsive behavior by traders when prices get close to entry or exit points. There are often nagging second thoughts about a trade when prices begin to get close to the entry point. This doubt is really a form of self-doubt and often occurs when traders are not using a plan. The use of a trading plan releases traders from having to watch the market on a micro-level. The time saved can be spent analyzing the markets and acquiring more knowledge. Remember, the main point of a trading plan is to help increase disci- pline. A written plan is far superior to a mental plan. It is extremely difficult c24 JWBK147-Smith April 25, 2008 11:16 Char Count= How to Make Money Trading Options 295 Investment Mentoring Institute Options Trading Plan General Date_________________ Underlying Instrument Symbol____________ Underlying Instrument Bullish/Bearish?:_________ Price Scenario: ________________________________________________________ ____________________________________________________________________ _ ___________________________________________________________________ Options Implied Volatility: Bullish/Bearish_________________________________________ _____________________________________________________________________ _____________________________________________________________________ Other Considerations____________________________________________________ _____________________________________________________________________ _____________________________________________________________________ Strategy Action Plan Initial Trade Strategy:______________________________________________________________ Initial Entry Technique:__________________________________________________ _____________________________________________________________________ Commission:_______________________Margin:_____________________________ Initial Stop Loss________________________________________________________ Initial Stop Loss Technique_______________________________________________ Follow-up Strategy _____________________________________________________ _____________________________________________________________________ Notes:________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ FIGURE 24.1 Investment Mentoring Institute Trading Plan for the human mind to take into account all possible factors in a rational manner when they are not written down. A mental trading plan tends to become a plan composed of wishful thinking rather than hard critical anal- ysis. Furthermore, the written plan provides the opportunity for traders to conduct a post-mortem analysis on the trade (we will discuss this in detail later). It is probably easier for traders to acquire the discipline to fill out the trading plan than it is to acquire the psychological discipline necessary to function without a plan. c24 JWBK147-Smith April 25, 2008 11:16 Char Count= 296 OPTION STRATEGIES You should fill out a trading plan whenever you are thinking of trading. You may see a chart pattern or read an article in the paper and think that there is something worthwhile to follow up on. You may become bullish on a particular underlying instrument because of a particular analysis you have done. You should then fill out the trading plan before entering the position because it will enforce your self-discipline. A trading plan should address the two major styles of analysis, tech- nical and fundamental. I suggest that you analyze each trade from both perspectives. The elimination of one technique will leave you trading with one eye. The use of both techniques combined provides a synergy and it also allows you to eliminate absurd trades. Of course, most traders trade only with technicals. The trading plan outlined in this section does not include both technicals and fundamentals for purposes of illustration but you should modify the form to fit your par- ticular trading style. I’ve simplified the plan and only include a section on Price Scenario where you can make notes on your analysis of the funda- mentals and/or technicals of the underlying instrument. Make it yours and you will find your self-discipline enhanced. The first section of the trading plan should be composed of general information such as the name of the underlying instrument and the date. A second section includes your analysis of the underlying instrument. The third section is about the actual option(s) that you will trade. Here you will outline your attitude on Implied Volatility and other considera- tions. These other considerations could include a discussion of the current tradeoff between gamma and theta. Or it could outline a particular scenario you are looking for in the options. The final section is all about the actual strategy. Here you will iden- tify the contract month(s) and the strategy that is being initiated. You will then identify the initial entry technique. Then jot down the margin and commission. I have been trading for many years and I am always amazed at how much better my original plan is than what I end up doing. I change my plan in mid-stream far too often. When I go back and see what would have happened if I had simply stuck to my original plan it is nearly always better. Why? Because it is devised in an atmosphere of calm and cool reason rather than in the heat of battle. This gives a much clearer picture of the future and the best way to play it. It also creates a much better atmosphere for self-discipline. Here’s the plan; now stick to it. One of the key reasons why I recommend this approach to non- professional investors is that it helps to save time. You write the plan once and do not deviate no matter what happens in the future. This usu- ally means that you don’t have to call your broker to change orders very [...]... calls and puts, 268 synthetic longs and shorts, 272 Bull spread strategies, 183–195 buying a call and, 99 decision structure, 187–195 rationale for, 183–184 risk/reward and, 184–187 Butterfly spread strategies, 209–223 decision structure, 213–223 floor traders and, 3 interest rates and, 28 rationale for, 209–211 risk/reward and, 211–213 Buying a call strategy, 91–101 decision structure, 94–101 rationale for, ... investors The Investment Mentoring Institute provides training and mentoring for individual and institutional investors in stocks, futures, and foreign exchange Courtney Smith is also President and Chief Investment Officer of Courtney Smith & Co, Inc which manages money for institutions, family offices, and high-net individuals He is also the CEO and Chairman of Greater China Technology, Inc a company which... trades Study the profitability of your techniques and, more importantly, where you succeeded or failed from a self-discipline point of view Notice how the postmortem forces you to grade yourself and your techniques It forces you to learn more about trading It forces you to become more focused on education and self-discipline You will feel less pressure to make money and more pressure to become a better... President and Chief Executive Officer of Quantum Financial Services, Inc., a futures and stock brokerage firm Mr Smith was First Vice President and Treasurer of the New York branch of the Swiss bank, Banca della Svizzera Italiana (BSI) At BSI, Mr Smith managed mutual funds, client accounts, and was responsible for the trading activities of the New York branch as well as trading and marketing fixed income and foreign... creativity and trade-offs in, 76–77 multidimensional thinking and, 75–76 techniques for, 77–90 Strike price: in Black-Scholes Model, 44 buying a call, 95–97 buying a put, 107–109 covered call writing, 133 defined, 11–12 naked call writing, 118–119 as option price influence, 25–26 Synthetic calls and puts, 267–270 decision structure, 268–270 rationale for, 267 risk/reward and, 268 Synthetic longs and shorts,... spreads, 237–243 straddles, 254–266 synthetic calls and puts, 268–270 Value Line Model, 41 Vega, 29–30, 45, 49–53 Volatility See also Expected volatility; Historical volatility; Implied volatility defined, 60 importance of understanding, 59 lognormal distribution and, 64–66 probability distribution and, 64 randomness and, 61, 67 standard deviations and, 60–64 Wasting asset, options as, 26–27 Whalley... writing and, 116 naked put writing and, 152 option pricing and, 30 return-if-exercised and, 34–35 Interest rates: in Black-Scholes Model, 44 as option price influence, 27–28 In-the-money options See also Decision structures defined, 13–14 delta, 47 exercise decisions and, 15–16 expiration day and, 12 intrinsic value and time value, 21–23 Intrinsic value: defined, 21–22 delta, 24 exercise decisions and, 15–16... 31 Splits, of underlying stock, 16 Standard deviation of prices, 60–64 Stocks, 11, 16 See also Dividends Straddles, 249–266 construction of, 76 decision structure, 252–266 implied volatility prediction, 72 rationale for, 249–250 risk/reward and, 251–252 theoretical edge and, 52 Strangles: construction of, 76 implied volatility prediction, 72 rationale for, 249–250 risk/reward and, 253 Strategy selection,... closely for patterns of success and failure For example, I studied Elliott Wave Analysis for months I initiated many trades largely based on my Elliott Wave analysis I gave up on it when I studied my postmortems and realized that I rarely had a winning trade using Elliott Wave That doesn’t mean that Elliott Wave is not a valid form of analysis but it does mean that I couldn’t apply the concepts and make... decision structure, 146–149, 178–181 rationale for, 143–145 risk/reward and, 145–146, 177–178 Ratio covered put writing strategy, 160, 175–181 decision structure, 178–181 rationale for, 175–177 risk/reward and, 177–178 Ratio spread strategy, 53, 233–243 decision structure, 236–243 rationale for, 233–234 risk/reward and, 235–236 Rebalancing: neutral strategies and, 54–57 ratio covered call writing, 148–149 . 181 Expiration day, 12 13 Fair value, 23 Far-term/long-term option, 12 Financing costs, 3–4, 31 FLEX options, 11 Foreign exchange options: interest rates and, 28 Phi and, 48–49 Forward price, 61 Futures. decisions and, 16 Dividends: exercise decisions and, 16 naked call writing and, 116 naked put writing and, 152 option pricing and, 30 option specifications and, 16–17 return-if-exercised and, 34–35 Donchian,. understanding, 59 lognormal distribution and, 64–66 probability distribution and, 64 randomness and, 61, 67 standard deviations and, 60–64 Wasting asset, options as, 26–27 Whalley Model, 41 Zeta,